Moral Hazard's Main Address Is In Michigan

The concept of "moral hazard', whereby inefficient public policy actions and instruments create incentives for people not to bear the full consequences of their actions, is again under duress in Michigan. In the case of the federal government's financial bailout of General Motors (the new General Motors) and Chrysler, U.S. taxpayers were recently left holding the bag for $10.5 and $1.3 billion in income redistribution, respectively. But it does not end there. Michigan is again at the forefront of America's institutional assault on moral hazard, and this time it is not Michigan's automotive industry that needs a financial bailout, it is the city of Detroit, the industry's birthplace. In July, 2013, when Detroit city government filed for Chapter 9 bankruptcy (which in December 2013 was approved by U.S. Bankruptcy Judge Steven Rhodes, and allowed for reductions in pension benefits), the city had approximately $11.5 billion in unsecured liabilities, of an overall debt exceeding $18 billion. Emergency financial manager Kevyn D. Orr, an appointee of Michigan Governor Rick Snyder and former corporate bankruptcy attorney, has proposed employing the bankruptcy process to eliminate over $9 billion in municipal debt.

In September 2013, the Obama administration announced that it would provide nearly $300 million in combined federal and private aid (most of it federal funding) to help bailout a failed city government, burdened with public employee pensions and a collapsed local economy. The New York Times, in a September 26, 2013 article ("$300 million in Detroit Aid, but No Bailout", Jackie Calmes), reports that this $300 million financial bailout funding would include $140 million for transit improvements, including $24 million for city bus repairs; $100 million in urban redevelopment efforts, including $25 million for commercial demolitions; and $25 million in Homeland Security funding, with up to 150 firefighters to be hired. According to Michigan Democrat Senator Debbie Stabenow, "What is important is that this is not a one-time announcement. This is the first step." Senator Stabenow was correct in her prognostication, as the State of Michigan has actively entered the government bailout frenzy.

Just last week, to assist the City of Detroit to exit bankruptcy and protect 21,000 retired city employee pensions and health care insurance coverage, Michigan's Republican Governor Rick Snyder announced that the State of Michigan would provide up to $350 million of its tobacco settlement money over a 20 year payout scheme ($17.5 million per annum) to match a grant offer of $330 million from philanthropic foundations. Governor Snyder's offer is contingent on a successful settlement of the city's bankruptcy proceedings involving city government, state government (including the Republican-controlled legislature), municipal unions, city employees and retirees before the upcoming gubernatorial election in November, in which Snyder is up for re-election. Dan Gilbert, founder and chairman of Detroit-based Rock Ventures, and Quicken Loans, America's largest online mortgage lender, argues that what is truly needed, is "a Marshall Plan for Detroit." Gilbert, who has purchased millions of square feet of real estate in the heart of Detroit, has invested about $1 billion to help transform the city into a Midwest technology center.

According to the Governor, "This is not a bailout of paying the debts directly of the city of Detroit. This is not a bailout of banks and other creditors. This is focused on helping reduce and mitigate the impact on retirees. This is to help people in our state." Back in July 2013, however, Governor Snyder was quoted on the same topic: "If you are asking, are we going to bail out the city of Detroit, the answer is no. Neither the federal government nor the State of Michigan should bail it out."

Previous to Governor Snyder's financial bailout announcement, federal judge Gerald Rosen, chief mediator for Detroit's Bankruptcy Mediators, recently announced that a consortium of nine national private foundations had offered $330 million to the Detroit Institute of Arts (DIA's) to purchase the museum's entire collection of artwork. If the terms of the consortium's offer are approved, and this offer does come with a number of conditions, all of the art would remain in the museum, while the $330 million would be directly allocated to the city's underfunded two (municipal and school) pension systems, in deficit to the tune of $3.5 billion, as well as $1.45 billion in pension debt and general obligation bonds sold by Detroit city government.

Detroit's creditors have been pressuring the city to sell the museum's art collection. In December 2013, Christie's Auction House, which had been hired by the Detroit city government, appraised the museum's collection of nearly 2,800 major works of art (among a 60,000-piece fine arts collection) at between $454 million and $867 million at auction. Other outside estimates place the value of the DIA collection at up to $8 billion. Within the last two weeks, however, U.S. Judge Steven Rhodes, who is overseeing the bankruptcy proceedings, rejected creditors' requests to formally appraise the DIA's world-class collection, which includes the works of Caravaggio, Matisse, Monet, Van Gogh, and Warhol.

In an article in The Washington Examiner on January 23, 2013 ("Detroit Bailout Plan Will Only Dig the Pension Hole Deeper"), Shikha Dalmia, columnist and Reason Foundation senior policy analyst offers a cogent argument for not rewarding decades of corruption and incompetence on the part of Detroit city government:

"Among their [Detroit city government's] many exotic practices include handing out investment returns generated in good years as a Christmas bonus check to retirees. If they had saved the money, as per Accounting 101, the pension shortfall would have been cut in half.

Asking state taxpayers to compensate Detroit retirees for money they've already enjoyed would be outrageous under any circumstances. But it's especially so given the state already hands Detroit almost twice as much revenue on a per capita basis as any other city. Motown is also the only city that is allowed to assess a special wagering tax on its casinos. What's more, between 2005 and 2011, the state helped the city borrow $610 million.

Rewarding the city's profligacy even more won't just create a moral hazard, encouraging more bad behavior in the expectation of future bailouts - it'll also prevent the deepest possible restructuring right now (emphasis added)."

On January 29, 2013, emergency financial manager Kevyn D. Orr provided creditors with a court-ordered confidential proposal on just how much of Detroit's $18 billion debt the city intends to pay back to its 100,000 creditors. The proposal, a "plan of adjustment, which is to be formally filed no later than March 1, 2013, in federal bankruptcy court. Earlier, Orr released a preliminary proposal to creditors which would pay pennies on the dollar for the $11.5 billion in unsecured debt. "We need to move quickly and efficiently. My team and I believe this plan presents each interested party with fair and equitable treatment, and we look forward to working with our creditors to adopt this plan and put Detroit back on the path to stability and success", Orr said in a written statement.

With upwards of nearly $1 billion in federal, state, and non-profit financial assistance (so far) proposed, and upwards of 100,000 creditors having to take a major financial "haircut" to erase municipal debt, the city of Detroit is certainly not bearing the full consequences of its actions. As Steve Spenser, a financial adviser for Guaranty Insurance Company, one of the municipality's creditors argues in a prepared statement, "[I am] troubled by the policy implications of the state favoring art ahead of the economic realities and recovery interests of the city's pensioners, bondholders and other unsecured creditors. We find it incredible that the city is being allowed to leave such a valuable art collection untouched when it can't provide basic services and is proposing to essentially walk away from its debt." With its still declining population of some 700,000 residents, does Detroit have a sufficient tax base to support basic municipal services after a financial bailout?

So what is Detroit willing to offer to "reinvent" itself? The emphasis of all recent public policy efforts appears to be focused on saving Detroit's assets, whether its public employee pensions and benefits or fine art collectables, rather than meeting the city's legal financial obligations. Outside of a plan announced last October to replace health care benefits for municipal retirees under age 65 with a $125 monthly stipend to buy coverage under the Affordable Care Act, and those 65 and older would transition to Medicare, with the city paying all or most of the premiums, there has been little heard from city representatives. This health care benefits transition - a welcome policy change - is projected to reduce the cost of annual retiree health care from $170 million less than $50 million.

While the DIA collection could be used as collateral for a loan, if the city defaults, the art used as collateral could be possessed by the loan originator. Under Detroit's dire financial circumstances, that may be an acceptable risk. Considering the quality of the fine art collection, another option is to rent the collection out to other museums; this would appear to be a "no brainer" decision for Detroit's government. Other suggestions that should be seriously considered would be selling the city-owned Belle Island, a former tourist attraction, which could be zoned for acceptable commercial development, or the city's water purification system, both of which could generate hundreds of millions of dollars in revenue. Before Michigan residents (the other 93 percent of the population) invest in "Reinventing Detroit", they need to see far more financial "skin" in the game from those accountable for the existing fiscal disaster. In this instance, public financial assistance needs "ropes', not "strings", attached. As a "creature" of the state of Michigan, Detroit city government will need to have active state-level accountability over the next decade.

However, the repercussions of how the fiscal crisis in Detroit will potentially have an impact on other financially distressed municipalities in Michigan - and perhaps beyond the state - is now in play. James Hohman, affiliated with the Michigan-based Mackinac Center for Public Policy, a free market think tank, notes in Shika Dalmia's above cited article, that no distressed municipality in Michigan since 1988 has received a [financial] bailout, even ones under receivership. Hohman adds that the unfunded liabilities of just the third of all the municipalities that belong to the Michigan Municipal Employers' Retirement System consortium is currently close to $3 billion. So, if Detroit gets bailed out, by what logic would all these municipalities be turned down? Extending this federal/state bailout model nationally, The Wall Street Journal ("Cities Grapple With Funding", Jeanette Neumann, October 28, 2013) evaluated data for 2012 on cities nationally dealing with similar issues faced by Detroit, and found that of the 250 largest (by population) U.S. cities, more than half still have financial reserves below their 2007 levels.

"Let's put this behind us so we don't have ongoing lawsuits ... so we all can focus on growing Detroit" may be Governor Rick Snyder's sentiment, but there are many residents of Michigan who still ascribe to the philosophy of moral hazard (along with other sympathizers nationwide) who await the details of the plan of adjustment to be submitted to the Bankruptcy Court, with hopes that it is a meaningful, equitable resolution which assures them that a re-occurrence of this fiscal crisis does not await Detroit later in the decade.